Issue
When a company is incorporated as a Limited Liability Corporation
("LLC"), the company gives some employees incentive units which vest
when certain conditions are met (e.g. employment period exceeds three years).
The employee has the right to purchase these units which are voting equity units at a strike price
which is stated in advance.

This summary assumes that the
unit’s strike price is higher than the fair value at the time the unit is
vested.

Authoritative Literature

After searching both
published and unpublished literature and inquiring with various technical
publications we found no technical literature that addresses incentive units in
LLCs or partnerships. Inquiry with the American Institute of Certified Public
Accounts showed that there is no authoritative literature in effect.
Some accountants have treated such equity instrument in the same manner of stock
options, as mandated by APB 25 and FAS 123.

Financial Account Board’s
Financial Accounting Statement No. 123 ("FAS 123") Accounting for
Stock-Based Compensation superceded APB Opinion No. 25 Account for Stock Issued to Employees. The main effect of FAS 123
over APB 25 is that under the preferred FAS 123, fair value is measured
by a stock-option value method and not by the "intrinsic value"
method prescribed in APB 25.

According to FAS 123 it
"applies to all transactions in which an entity grants shares of its
common stock, stock options or other equity instruments to its employees,
except for equity instruments held by an employee stock ownership plan".
This application is in connection to "providing goods and services",
by either employees or suppliers (par. 6).

Stock Options and
Incentive Units

LLC’s incentive units appear
in substance to be similar to stock options. They have a pre-determined vesting
conditions and periods, pre-determined price and similar business reasons of
granting, i.e. compensating employees without cash outflow. Internal Revenue
Code ("IRC") section 424 governs the application of incentive stock
options.

Some differences are present
however:

Deductibility
of Stock Options by Employers

Incentive
stock options trigger ordinary income to the employer equal to the proceeds
received from the employees. These options are also not subject to ERISA but a
report of incentive stock options exercised is required as supplementary to the
W2 report to employees.

Incentive
units in an LLC are, under FAS 123 allocated over the vesting period as
compensation costs (or payment to service provider, if given to non-employees).

Who may be
given incentive units?

Incentive
stock options are options given to employees to purchase stock at favorable conditions,
with little risk of loosing if the stock underperforms when the option is
vested. They are granted only to employees who own less than 10% of the voting
power in the employer’s stock.

Incentive
units, if viewed as stock options do not have such restrictions and can be
granted to non employees (e.g. suppliers); Incentive units granting disregards
the current ownership level of the recipient.

Limitation
on incentive units:

Incentive
stock options are limited in their vesting schedule for $100,000 per year for
tax purposes.

Incentive
units, treated like stock options do not carry such limitation.

Accounting Treatment of
Stock Options

Both APB 25 and FAS 123 are
acceptable treatment, although FAS 123 is preferred. However, if APB 25 is
adopted, pro-forma income statement should be disclosed to the results under
the fair-value method prescribed in FAS 123 (par. 45).

Under APB 25, companies
recognize compensation expense stemming from employee stock option based on the
difference between the strike price (typically lower, and the fair value of the
stock on day of grant. That difference in the proceeds from employee’s stock
option is attributed to compensation and is recognized as compensation expense
under APB 25. For example, on January 1, 2001 an employee is granted a strike
price of $10. The employee exercises their strike price on January 1, 2001. The
employee stock option vests on December 31, 2003. On December 31, 2002 the
stock’s value is $17 on the open market. On December 31, 2003 the company grants
the employee the stock – which is now vested and recognizes compensation
expense of $7 per share.

Under FAS 123, the excess of
the projected estimated fair value (par. 9) of the stock option upon vesting
over the strike price is allocated over the service period (par. 30). The
service period starts at the date of exercise and ends at the date of vesting.
The projected price of non public companies may result in a minimum value for
the stock option because market price volatility is unknown. For example, an
employee exercises a stock option on January 1, 2001 at a strike price of $10
per share and the stock option vests in three years, on December 31, 2003. On
January 1, 2001 the stock option fair value, using a projection model, is
estimated to be $19 per share. The company will recognize a $3 ($9 / 3 years =
$3) per year of compensation expense. On December 31, 2002 the employee’s
option is vested and the company grants the employee a stock.

While the employee’s option
is not vested the company also reclassifies the unissued stock as restricted.
Generally, the projected fair price (in the example above, $19) is the value
upon restriction.

Some Employee Stock Option
Plans (ESOP) does not qualify as stock options that trigger compensation
expense recognition. Generally, when employees can purchase the stock at a
small discount (de-minimus), and when substantially all full time
employees qualify, the excess of the fair value of the stock over the strike
price is not compensation expense to the company.

Other issues

Repurchase agreement

A mandatory repurchase agreement does not change the
accounting treatment of stock-options (par. 219).

Dividends

Generally, additional compensation for dividends on unvested
stock options, or stock options that allow the employee to keep such dividends
is charged as compensation expense in the period of payment.

Tax Effects

Generally, prepaid
compensation expenses are not tax deductible. The time value of the
compensation, which is "built in" the projected estimated value upon
the option’s vesting is also not tax deductible. Therefore, a temporary
difference (resulting in a deferred tax asset) is accounted for based on the
accumulated applicable compensation costs and reduced by a valuation allowance
(par. 227).

Once vested and granted, the
actual compensation cost in excess of the accumulated compensation cost that
was used for the deferred tax asset should be recognized as additional paid in
capital and not as deferred tax asset (par. 228). However, if the actual
compensation cost is below the compensation cost that was used for the deferred
tax asset, the write off should first be taken from additional paid in capital
that is attributed to any prior excess, and then as an expense on the income
statement. (par. 229).

Summary

Incentive units are more
similar in substance to stock options than to incentive stock options. Although
no direct authoritative literature exist to mandate the accounting treatment of
an LLC’s incentive units

FAS 123 require the fair
value method to be applied to the stock options upon exercising them by the
employee or service provider. The excess of the projected fair value of the
option over the strike price should be allocated over the vesting period. When
the stock vests, the difference between the accumulated allocation and the
actual fair value of the option is charged to APIC.

If the vesting and
excersising occurs simulataniously, the charge is to the period of exercised
and the difference if to APIC for excess or as a loss to the income statement.